Putting Together the Pieces of the Knight Capital Group Puzzle

Knight Capital Group ($KCG: no positions) had a huge error Monday morning, yadda yadda yadda, they lost $ 440MM and are scrambling to come up with capital to remedy their situation. Now let’s look into the details of this still developing story and see what we can hypothesize.

When this story first broke, it was a bit different from other “algos gone wild” stories we’ve seen in recent history: there were 140 stocks affected, and they were on both the buy side and the sell side. This led me to believe, based on my experience on a large program trading desk, and having heard numerous legends of traders who have done exactly the following, that someone at NITE (I’m gonna call Knight Capital Group “NITE” throughout this piece – their OTC trading acronym) executed an order over the wrong time period. In other words, maybe the order was supposed to take all day, and they sent it down for 30 minutes by accident. The official story coming out of NITE quickly rebuffed my theory – they blamed it on a software bug. While I’d normally be awfully suspicious of the old “it was a software bug that caused us to suddenly start sending out an abomination of orders that caused us to lose almost half a billion dollars” excuse, it makes some sense here for an important reason: The New York Stock Exchange rolled out their own new “dark pool” which competes with NITE on Wednesday.

So, as some media sources have started to report (and I also thought might have contributed initially), it seems likely that NITE altered some of their software code to account for this new NYSE outlet, and seems to have, how do you say this politely without understating it… Let me just go with: “FUCKED IT UP ROYALLY.”

Strangely, however, Fox Business’s Charlie Gasparino Tweeted a full day later another explanation that was right back with my initial reaction – that the error was a result of a huge order that was supposed to take days or weeks to execute but was instead liquidated in a hurry in error. Now, it’s not that Gasparino can’t be wrong – but it is indeed curious that he got ahold of this story from somewhere, and reported it a mere half hour after a seemingly conflicting explanation from the company. Is it possible that NITE’s old algos allowed a trader to execute an order over multiple days, but that the new update resulted in ignoring start and end date? In other words, perhaps an order was entered into NITE’s system with a start parameter of 9:30am, Wednesday August 1st, and an end parameter of 10:00am Wednesday August 8th, but that the software “glitch” resulted in ignoring of the end date? Who knows – I am purely speculating here – and I have never, in fact, used a system that let me enter an order for a multiple day timeframe. In my old job, if I wanted to spread an order over two days, I’d cut it in half and execute half on each day, using whichever execution method I chose. In any case, NITE’s official description of the problem was that

“As previously disclosed, Knight experienced a technology issue at the open of trading at the NYSE yesterday, August 1st. This issue was related to Knight’s installation of trading software and resulted in Knight sending numerous erroneous orders in NYSE-listed securities into the market.“

But wait – fast forward to Friday afternoon, where CNBC’s Kate Kelly reports that Goldman Sachs took the other side of NITE’s unwind of the positions. Kelly writes:

“It was Goldman Sachs that helped Knight Trading Group to unwind its inadvertent purchase of 148 stocks on Wednesday, say people familiar with the matter, and the transaction cost the brokerage firm $440 million – a price tag that has left Knight scrambling for extra cash….

Under trade-settlement regulations, the Knight-Goldman block transaction must settle three business days after the initial agreement, which means the seller must come up with the $440 million in cash by late Wednesday. As of June 30, Knight had about $365 million in cash, according to a securities filing – raising important questions about whether the brokerage firm could generate the additional money by early next week.”

First of all, I think Kelly had a typo with “late Wednesday” in the latter paragraph: the trade date was Wednesday, and the settlement date would be Monday, August 6th. I find this part interesting, though, because this is the core of my old business in my prior “working stiff” life.

I worked on a top tier program trading desk, where a big part of our business was committing capital to take risk off of our clients’ hands and put it onto our own books where we could manage it and liquidate it. In this case, it seems that’s what Goldman did for NITE: GS committed capital and NITE sold their error portfolio (sold the longs, bought back the shorts) to Goldman. Of course, Goldman didn’t do this out of the kindness of their own hearts – they charge NITE a “principal” or “risk” commission for this service. But it’s important to understand that this commission wasn’t $ 440MM. In other words, Goldman didn’t say to NITE “we’ll take care of this for you for $ 440MM.” I don’t know the details of the actual size of the portfolio (and thus, the risk) that was transferred, but let’s just say that NITE had mark-to-market losses of $ 410MM at the close of trading, and Goldman charged them $ 30MM to take over the risk – that’s how you get to $ 440MM. Yes – I completely made those numbers up: it could have been $ 400MM vs $ 40MM, or $ 420MM vs $ 20MM. The important thing to understand is that Kelly’s headline: “Goldman Sachs prices Knight Unwind at $ 440MM” is pretty much a complete bastardization of the reality of the situation, and implies that GS charged NITE $ 440MM: that this sum is profit that GS made. That’s not the case: $ 440MM is the difference between NITE’s erroneous executions in the market, and their “unwind” with Goldman Sachs. Hypothetically, if Goldman Sachs was on the other side of everyone of NITE’s erroneous market executions, THEN Goldman would make $ 440MM on this trade.

Astute readers will notice something else: NITE’s press release said “Knight has traded out of its entire erroneous trade position.” Of course, Knight liquidating the error in the marketplace and Knight transferring the error to Goldman Sachs are two entirely different scenarios. In both cases, NITE has eliminated their own risk, but in the latter case – which seems to depict reality – Goldman still has risk on their books.

What’s interesting here, though, is that it seems as though NITE may have screwed up so colossally that they couldn’t trade out of their error in the marketplace – because they didn’t have the capital to do so! I wrote a post almost a year ago about trading errors. The cardinal rule is that you don’t sit on it, and you trade out of it ASAP. Of course, executing a 50,000 share order as a sell instead of a buy, or buying 100,000 shares of stock instead of 10,000 isn’t quite the same magnitude as NITE’s error, but anyway…

So imagine NITE’s executives are sitting there at lunch on Wednesday, having tabulated their positions and calculated the mark to market losses, and they’re saying “Ummm. We can’t trade out of this in the marketplace – we can’t afford to.” Now, that doesn’t mean that the solution is to put the trades away in a locked filing cabinet and hope and pray that the marks come back – that doesn’t help you: you still have to settle in three days. Hence, they went to Goldman and tried to work something out. But guess what – transferring the risk to Goldman also doesn’t magically give NITE the capital to settle the trades. Which brings us to the next piece of the puzzle. I can’t find this story online, but a friend emailed me Friday afternoon:

* “The exemption was granted on the basis, among other things, that an on-floor transfer was impractical in view of the
number and size of the positions.’’

* Transfer is on wide array of options on “several hundred” options classes

What that story is saying is that NITE got permission to transfer a boatload of options positions without crossing them on the exchange. To me, this says “NITE is selling their options business.” This makes sense, of course: they need capital to cover their error, so they’ll sell off business to try to save some part of the firm. It’s even possible that Goldman would accept pieces of NITE as settlement for the risk trade! Alternatively, Goldman could advise NITE on the sale of some businesses, simultaneously making sure that Goldman’s own interests (after all, they are the ones exposed to the trade settlement) are protected.

I have been at The Cape for the past 2 days indulging in stuffed quahogs, crabcakes, lobster and wine. I have not been plugged in to every Tweet about the latest on the NITE situation, so forgive me if I erred above somewhere in my interpretation of The Facts As I Know Them thus-far. Also note that I have certainly speculated on a bunch of scenarios above.

EDIT (Sunday 8/5/12, Noon): I didn’t make it explicitly clear in this post, but I’d be shocked if we don’t hear news by Monday morning (or Monday afternoon at the latest) of some serious changes at Knight in terms of business segment sales, capital raise, etc. As I noted Saturday afternoon in this Tweet)

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